Let Warren Buffett Guide You on This Investment Vehicle

Warren Buffett

Warren Buffett has been investing in the stock market for more than 70 years. At only 11 years old, he made his first equity purchase — three shares of Cities Service Preferred. He sold early and made a small profit, but ultimately learned a lesson about patience as shares soared higher. Over the decades, Buffett has passed on a vast amount of wisdom to investors. One lesson investors should heed from the Oracle of Omaha involves leverage.

“When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious,” explained Buffett in his 2010 shareholder letter. “But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

More from Wall St. Cheat Sheet: The Millionaires Club: Congress Loves These 10 Stocks

Buffett was primarily discussing leverage in relation to personal debt, but the same principles apply to leveraged exchange-traded funds — a relatively new financial product. Leveraged ETFs are like regular ETFs laced with greed and impatience. They attempt to deliver multiples of the performance of an underlying index or benchmark they track. Some track broad indices, while others track specific sectors or commodities. Leveraged ETFs seek to magnify returns by using some of Wall Street’s favorite financial drugs: derivatives, futures contracts, and swaps.

Although leveraged ETFs can serve a meaningful purpose to day traders, longer-term investors should steer clear. For example, let’s say an index starts with a value of 100, while a leveraged ETF that seeks to double its return starts at $100. If the index drops by 10 points on Day 1, its value declines by 10 percent, to 90 points. In theory, the leveraged ETF would therefore plunge 20 percent on that day, with the index’s drop magnified two-fold, and have an ending value of $80. On Day 2, if the index rebounds 10 percent, the index value increases to 99. For the leveraged ETF, its value on Day 2 would also increase by 20 percent, but that 20 percent increase, from $80, would be to just $96.

The leveraged ETF accomplished its goal on a daily basis, but failed to keep pace over the two-day period. This gap can grow significantly for buy-and-hold investors, and be deadly in volatile markets. It’s even possible that investors could suffer significant losses while the long-term performance of the underlying index shows a gain.

More from Wall St. Cheat Sheet: Tax Season Is Coming: Avoid Fraud and File Early

The dangers of leveraged ETFs have been highlighted in recent years, but brokers and investors are still learning the hard way. The Financial Industry Regulatory Authority recently ordered Stifel Nicolaus and Century Securities to pay fines and restitution totaling more than $1 million for unsuitable sales of leveraged and inverse ETFs. Sixty-five customers were involved between the two St. Louis-based broker-dealers.

Brad Bennett, FINRA Executive Vice President and Chief of Enforcement, explained, “The complexity of leveraged and inverse exchange-traded products makes it essential for securities firms and their representatives to understand these products before recommending them to their customers. Firms must also conduct reasonable due diligence on these and other complex products, sufficiently train their sales force and have adequate supervisory systems in place before offering them to retail investors.”

More from Wall St. Cheat Sheet: Hawks vs. Doves: How Fed Policy Affects Jobs and Prices

FINRA found that between January 2009 and June 2013, Stifel and Century made inappropriate recommendations of non-traditional ETFs to certain customers because some representatives did not fully understand the unique features and specific risks associated with leveraged and inverse ETFs. Customers with conservative investment objectives suffered the worst and experienced net losses.

Before investing in a leveraged ETF, you should strongly consider what can happen if you hold shares for longer than one day, and whether the extra risks fit with your financial goals. Leveraged ETFs can also come with higher fees than traditional ETFs. Everybody wants a shortcut to build wealth, but it even took Warren Buffett decades to accumulate his impressive status.

More from Wall St. Cheat Sheet:

Follow Eric on Twitter @Mr_Eric_WSCS